Sunday, December 2, 2012

Acquisition Archives: Winners and Losers

In my last post, I looked at HP's disastrous acquisition of Autonomy for $11 billion in 2011 and its subsequent write off of $8.8 billion. While it stands out as a particularly egregious example of a bad deal, it is unfortunately not the exception. In fact, the evidence suggests that a growth strategy built around acquisitions, especially of other publicly traded firms, is more likely to fail than succeed. To back this statement, you can look at three pieces of evidence:
(a) the behavior of the acquiring company's stock price, around the announcement of an acquisition
(b) the post-deal performance (stock price & profitability) of firms after acquisitions
(c) the overall track record of acquisition-based growth strategies, relative to other growth strategies

The acquisition date: Uninformed investors or Delusional managers?
When an acquisition of a publicly traded company is announced, the attention is generally on the target firm and its stock price, but the market's reaction to the event is better captured in what happens to the acquiring firm's stock price. In the figure below, take a look at the target and acquiring firm stock behavior in the twenty days before and after the acquisition announcement across hundreds of acquisition announcements:
The winner in public company acquisitions is easy to spot and it is the target company stockholders, who gain about 18% over the 41 days. On average, bidding company stockholders have little to show in terms of price gains; the stock price for acquiring firms drops about 2% during the announcement period and about 55% of all acquiring firms see their stock prices go down. Note that while the percentage price drop is small (relative to the price increase for the target firm), acquiring firms are typically much larger than target firms and the absolute value that is lost by acquiring firm stockholders from acquisitions can be staggering. A study of 12,023 acquisitions by large market cap firms from 1980 to 2001 estimated that their stockholders lost  $218 billion in market value because of these acquisitions. While this number was inflated by some especially bad deals done between 1998 and 2000, they illustrate the potential for massive value losses from acquisitions and the reality that one big, bad deal can undo decades of careful value creation in a company.

There is one final interesting statistic that can be gleaned from the announcement date market reaction. If you take the cumulative market value of the target and acquiring firms, just before the acquisition announcement and just after, that combined value increases, on average, across mergers. For better or worse, this is what the market seems to be telling us at the time of acquisitions announcements: it believes that there is value added from synergy or other sources in the typical merger, while at the same time also believing that acquiring firms over estimate the value of the synergy and pay too much.

The long term: Post-deal blues?
The defense that is offered by acquiring company managers, when confronted with the market's negative reaction to the acquisition announcement, is that the reaction is rooted in ignorance. Acquiring company managers claim to have access to information and forecasts that stockholders don't have and argue that they are in a better position to value "synergy" and "control". It is of course true that managers have more information on target firm than their stockholders do, but the proof is ultimately in the pudding. To make a judgment on whether this superior information pays off in superior performance, let's look at whether acquiring firms deliver on the promised synergy and other benefits.
Post-deal stock price performance: KPMG studied the 700 biggest mergers between 1996 and 1998 and compared the stock price performance for a year after the deal was closed to that of the peer group to conclude that 83% of the companies underperformed after acquisitions. Thus, the negative reaction to acquisition announcements does not seem to dissipate over longer periods.  In some good news, KPMG has updated its M&A study five more times since its 1999 study and reports that there has been some improvement between 1999 and 2011. While only 31% of deals made in the last study (looking at 2007-2009 deals) were value adding, that is an improvement over the 17% from the 1999 study:
While this study can be faulted for its short time horizon (it looked at only the year after the merger for improvement), the consensus across many academic studies is that acquiring companies' shares under perform their peer group over long periods (extending 3-5 years).

Post-deal operating performance: The evidence is mixed on measures of operating performance. While there are some studies that find improvements in operating margins after acquisitions, these gains seem to be exist for a subset of acquisitions (hostile seem to do better than friendly) or only for sub periods. McKinsey has looked at mergers over three decades, asking two simple questions of acquirers: (a) Does the acquisition generate a return on capital that exceeds the cost of capital for the deal? and (b) Does the acquisition lead the acquirer to become more profitable than the peer group? In its studies that have spanned three decades, McKinsey found that most acquirers fail at least one of the two tests and that many fail both. 

In summary, if the sales pitch for an acquisition is that it will help boost the acquirer's stock price and improve profitability, relative to the peer group, there is no evidence that either happens, at least on the typical acquisition.

Growing through acquisitions
For better or worse, some companies choose to grow primarily through acquisitions and it is true that some succeed. For instance, Cisco transformed itself from a small technology company to the largest market cap firm in the world (very briefly in 1999) by acquiring dozens of other companies.

Firms are often attracted to an acquisition-based growth strategy, because it seems to offer a speedier pathway to success, but acquisitions are not the only option for growth. A company can develop new products, take existing products in new markets or try to capture a higher market share of an existing market. The question then becomes not whether a company should grow, but the most efficient way to seek out that growth. Drawing again on a McKinsey study of different growth strategies in the consumer goods industry over several decades, we see a disturbing picture:

The payoff to investing in growth is greatest for new-product development, where a million invested in the strategy generates additional value of $1.75 million to $ 2 million, and generates the most bang for the buck (with share prices doubling with relatively small revenue growth of 5-6% from the new products). The payoff to growth investing gets steadily worse across the next four strategies and is worst with acquisitions, where a million investing in acquisitions generates between -.5 million to $.2 million in additional value.

There are shades of nuance that are missed in this aggregate picture. As I will note in a later post, there are subsets of acquisition strategies that do better; buying smaller rather than larger companies, private as opposed to public companies and strength-focused rather than me-too acquisitions. Notwithstanding these pockets of success, it remains true that it is difficult to create value with an acquisition-based growth strategy and it becomes even more so as the company gets larger. In fact, Cisco is a good example of the diminishing returns to acquisition-based growth, as the same strategy that worked to great effect in the 1990s worked against the company between 2001 and 2010.

And the disease is spreading
The scariest aspect of the acquisition disease (which destroys value) is that it is now spreading to emerging markets. Emerging market companies, which used to be targets for richer developed market companies, are now in a position to be acquirers and some of them are targeting developed market icons. Looking at the prices they pay, and the practices they adopt, it is also clear that emerging market companies are making the same mistakes that their developed market predecessors did. A study of the stock price behavior in the days before and after the announcement of 114 acquisitions of US companies by Indian companies  illustrates the problem:
Indian acquirers: Months before & after acquisitions
While the initial reaction to acquisition announcements is positive, market disillusionment with the acquisition sets in quickly and the cumulative returns deplete over time, turning negative as you get to 20 days after the announcement.

Why do companies persist?
Given this history of value destruction, you would think that companies would become more measured in pursuing acquisition-based strategies. That, unfortunately, does not seem to be the case. Not only do we continue to see big, bad deals, but we often see the same company repeatedly making bad deals and the same mistakes repeated over and over by other companies. Not only is there no learning built into the process, but this repeated losing behavior would suggest that there is some collective irrationality at play (a euphemism for insanity) or that the acquisition process is flawed, and in the posts that follow, I will take a closer look at both possibilities. I will begin by by putting the objectives and incentives of the key players in the acquisition process under a microscope, starting with the top managers in both the acquiring and target companies, following up with the "advisors" (investment banks, commercial banks and consultants) on these deals, and ending with the accountants whose job it is to provide information on the deals. I will then look at the mechanics of the process, first focusing on common errors that I see in acquisition valuations and then looking at how best to value "control" and "synergy". I will close with a post on how to improve the odds of success with an acquisition-based growth strategy, drawing on lessons from history.

The Acquisition Series
HP's deal from hell: The mark-it-up and write-it-down two step
Acquisition Archives: Winners and Losers
Acquisition Hubris: Over confident CEOs and Compliant Boards
Acquisition Advice: Big deal or good deal?
Acquisition Accounting I: Accretive (Dilutive) Deals can be bad (good) deals
Acquisition Accounting II: Goodwill, more plug than asset

19 comments:

Nat Kausik said...

Nice analysis but not convinced that it applies to the HP/Autonomy case.

HP's problem with the Autonomy acquisition was caused by the unusual combination of a weak CEO and poor board oversight. It was an open secret in the industry that Autonomy's accounting had issues.

Aswath Damodaran said...

Nat,
As I noted, I think HP is an extreme case. The points you make about corporate governance are general ones that I think characterize poor acquisitions, though a headstrong CEO is more common than a weak CEO. As for the accounting issues, fair enough, but the question is not about Autonomy's accounting issues and value but why HP would buy Autonomy in spite of these issues being common knowledge.

Jonathan Bresler said...

Would suggest that one reason that acquisitions occur and corporations persist in acquiring other companies is that the managers bonus metrics are tied to the successfully completing the acquisition (immediate goal), rather than to the success of the acquisition (long term goal).

Once the acquisition is done, others (often? nearly always?) within the combined company are tasked with realizing the value of the acquisition.

This is based upon reading accounts of various acquisitions as well as a personal exposure to a very small number of them.

CF Chaser said...

Hi Professor,
I was wondering if you would be able to shed some light on the recent spat between Olam International and Muddy Waters.
Olam is or has been a darling on the Singapore Exchange which has been aggressive on acquisitions. The CEO claims that out of 22 acquisitions in the last few years, 11 of them were purchased below their identifiable net assets and liabilities, allowing the recording of negative goodwill. How is it possible that a company can constantly purchase companies below their book value? In your opinion, would this not be a red flag for investors that something fraudulent is going on or that management at the very least is throwing good money after the bad?
A second question I have is that mining/resources companies in general are probably the most aggressive in acquisitions. Would this mean that the industry as a whole destroys value, or is it a catch 22 situation where they just have to buy into more companies as their assets have a limited life or just risk being liquidated once their assets are depleted?
Thanks.
Jon

suresh v said...

People not learning from mistakes in finance? I guess this is perhaps due to an inflated sense of intelligence, and control over things uncontrollable. Afflicts every walk of life. Fo rexample, why do people get into the movie industry. Kahneman, Tversky, Thaler & Shiller rule!

garethwobg said...

Hey Prof

very timely piece,

agree with your analysis, I know well quite a few of these top CEOs /Board directors... sadly there maybe other reasons ontop of the pressure of advisers and very sad fact is that at present capital market is about Vanity & Debt & short term incentives

1) Vanity of "being the deal makers" , whether successful or not.. HP& Autonomy = failed but eBay & Skype was a success as Meg managed to offload it Microsoft for a profit!?

2) Debt fueled everything era is still alive and well despite it created millions of zombie firms now worldwide.. should "efficient use of capital" still be equal to debt any longer!??

3) shorterm-ism rules the day now, given spot price changes of share price (don't forget it is market sentiments and not equal to absolute viability of companies) and short term appointments of CEOs (max 3-5years if lucky) and their short term incentives means it makes much more sense for them to make the short term deals as they can get their bonus or options in time before they parachuted or head-hunted out (unless they mess up and get sacked with a golden goodbye)....

plus of course the "market" fueled by likes of CNBC, reuters, bloomberg as volatility for them means better business!! (nothing wrong with that, loads of good friends for me in that sector, but this IS the status quo!!)

Therefore, if you are doing any analysis, I would implore you to take into account for not listed firms and also family dynasties and conglomerates (mostly private now) and we should be able to really understand the real reasons behind all these.. !??

hope I made sense!?

BR

@GarethWong

Vivek said...

Sir, the post does not talk enough about what can be done to avoid falling in the trap of making such a deal. The incentive for an executive to push the deal can be a big bonus post closure of the deal, but what about the impact of a big deal gone bad on one's career. How can one avoid such a trap??

Dan Axelsen said...
This comment has been removed by the author.
Dan Axelsen said...

Dr. Damodaran,

I hear this argument frequently, generally suggesting that M&A destroys value. I just wonder if there aren't a few fallacies that should be considered:

1. Imagine two companies are both worth $10 ($20 in aggregate) and they merge. If the remaining company is later worth $15, one might say $5 of value has been destroyed, and one might point to the merger. However, if you'll consider an alternative universe in which both of the companies remained independent and both declined to $5 ($10 in aggregate), then it might be the case that a merger provides $5 of value in such a situation. Basically, the merger might have slowed an inevitable decline. However, in that hypothetical situation, no study will ever suggest that value was created in through M&A.

2. It is easier to measure "value destruction" (by looking at accounting writeoffs, share price declines, etc) rather than value creation through M&A. It is actually very common for M&A to create value, we just can't tell what it is. Most of Google's lucrative businesses were acquired (their advertising businesses came from Adwords and AdMob, their phone business came from Android and Motorola, their video business came from YouTube, etc). Likewise, most of EMC's value has come from the acquisition of VMware, Isilon, and others. The best parts of many tech behemoths have come from M&A: Apple acquired NeXT, eBay acquired PayPal, Amazon acquired many of their biggest businesses such as Zappos...

Even failed acquisitions have defensive value. If Google acquires a search engine for a huge price, and promptly shuts it down and writes off the whole value, that would still be an "NPV positive" decision, if management was sure that the target search engine was a real competitive threat. However, it is easy for an observer to criticize it as a mistake.

Another point is that ***these acquisitions enabled the very survival of many of these companies*** (where would Apple be if they hadn't acquired NeXT?), so even if the parents companies in these cases lose money on 99% of their deals, M&A was the right way to go. Remember that Yahoo! passed on acquiring Google, Facebook, and many other companies that now threaten Yahoo!'s existence.

I just think saying "the evidence suggests that a growth strategy built around acquisitions [...] is more likely to fail" is an easy and conventional thing to say, and probably not sufficiently considered.

Thanks for the post, and for reading.

Aswath Damodaran said...

I am afraid that you are reaching for straws on these arguments. Are there some defensive acquisitions that work? Sure. Do some companies succeed with acquisitions? Absolutely. But my point was about the aggregate evidence, which strongly suggests that even if mergers work, acquirers pay too much and target company stockholders reap too much of the benefits.

Anonymous said...

Not necessarily reaching for straws - it is a case of information asymetry. Management of a firm sees a challenging future that the market does not, and takes action to address it. Two things happen - some of the asymetric information is released, and thus the stock is discounted to reflect it, and potentially the firm improves it's future position.

So management knows it's $10 valuation is going to $5, so it uses the $10 valuation to buy a company that helps arrest the decline and get them to $7.50.

Without knowing what the results would have been without the merger, we can not truly assess whether the merger the rightdecision to the shareholders of the firm given the circumstances.

Dan Axelsen said...

Right - the Anonymous commenter above gets what I'm saying. Imagine, for example, Yahoo! had acquired Google for $10 Billion (or some huge number) very early on, such as when it passed on Google for only a millions dollars. Imagine then that it immediately wrote off the whole value - you would probably consider it evidence of hubris and value destruction.

However, such an action would still have created value for Yahoo!, because it would have allowed it to remain the top search engine, and preserve far more than $10 Billion in market cap.

Obviously this example is extreme and only in theory, but I believe this happens all the time, we just couldn't possibly know about it because we can't observe multiple possible outcomes.

Anonymous said...

I think Dan's first point is actually a point against acquisitions.

It is quite possible that both companies would lose value and then the M&A stock decline isn't really the M&A's fault.

However, most stock markets in the world go up much more frequently then they go down, no matter the timeframe. So, from that reasoning, it is very likely that most companies would see their value go up. Instead, after the M&A, the company loses not only the value from the previous point (as research sounds), but much more since the stock price should go up with the market but it doesn't do that.

I'm not sure if I'm making myself clear (non-native english speaker). The main point is that, since usually markets go up, counting the pre-M&A price as the starting point for comparison actually understates the destruction of value on average, even though in some specific cases the M&A may prevent that uncommon decline.

Anonymous said...

Comment on Nat's remark -

I agree with Prof.'s comments in general, and these apply specifically to HP too.

Most acquisitions are driven by overconfidence and ultra-high egos - hubris. If price paid for something is way in excess of its value, what do we have to say?

All bad acquisitions are made by weak CEOs and poor board. HP is no exception here.

Acquisition makes sense only when it provides excess returns.

In HP's case it was not to be and in a shocking manner it had to reverse too quickly (Usually stupid prices paid are charged off over a period of time: slow write-offs).

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